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1-1 Financial Statement Analysis L1: Overview of Financial Statement Analysis www.notes638.wordpress.com
1-1
Financial Statement Analysis
L1: Overview of Financial
Statement Analysis
www.notes638.wordpress.com
1-2
Business Analysis
Evaluate Prospects Evaluate Risks
Business Decision Makers
Equity investors
Creditors
Managers
Merger and Acquisition Analysts
External Auditors
Directors
Regulators
Employees & Unions
Lawyers
1-3
Information Sources for Business
Analysis
Trade reports
Regulatory filings
Economic Indicators
Industry Statistics
Financial Statements
Quantitative
Web sites
Vision/Mission Statement
Financial press
Press Releases
Chairperson’s Letter
Management discussion & Analysis
Qualitative
1-4
Types of
Business
Analysis
Credit Analysis Equity Analysis
Management &
Control
Mergers, Acquisitions
& Divestitures
Director OversightRegulation
External Auditing
Labor Negotiations
Financial
Management
1-5
Credit Analysis
Trade Creditors
Provide goods or services
Most short-term
Usually implicit interest
Bear risk of default
Non-trade Creditors
Provide major
financing
Most long-term
Usually explicit interest
Bear risk of default
1-6
Credit Analysis
Liquidity
Ability to meet short-
term obligations
Focus:
• Current cash flows
• Make up of current
assets and liabilities
• Liquidity of assets
Solvency
Ability to meet long-
term obligations
Focus:
• Long-term profitability
• Capital structure
Credit worthiness: Ability to honor credit obligations
(downside risk)
1-7
Equity Analysis
Technical analysis / Charting
• Patterns in price or volume history of a stock
• Predict future price movements
Fundamental Analysis
Determine Intrinsic value
without reference to
price
• Analyze and interpret
key factors
– Economy
– Industry
– Company
Assessment of downside risk and upside potential
1-8
Prospective
AnalysisAccounting
Analysis
Business
Environment &
Strategy Analysis
Industry
Analysis
Strategy
Analysis
Financial
Analysis
Analysis
of cash
flowsProfitability
Analysis
Risk
Analysis
Cost of Capital Estimate Intrinsic Value
Component Processes of
Business Analysis
1-9
Accounting Analysis
Comparability problems — across firms and across time
Manager estimation error
Distortion problems Earnings management
Accounting Standards
Accounting
Risk
Process to evaluate and adjust financial
statements to better reflect economic reality
1-10
Financial Analysis
Profitability analysis — Evaluate return
on investments
Risk analysis ——— Evaluate riskiness
& creditworthiness
Analysis of — Evaluate source &
cash flows deployment of funds
Common tools
Ratio
analysis
Cash
flow
analysis
Process to evaluate financial position and
performance using financial statements
1-11
Prospective Analysis
Intrinsic Value
Business Environment
& Strategy Analysis
Accounting Analysis
Financial Analysis
Process to forecast future payoffs
1-12
Dynamics of Business Activities
End of period
Beginning of period
Business Activities Time
Investing
Operating
FinancingPlanning
Planning
FinancingInvesting
1-13
Business Activities
Planning
Activities:
Goals
& Objectives
Competition Pricing
Market demandsTactics
Promotion
Managerial performance
Opportunities
Projections
Distribution
Obstacles
1-14
Business Activities
Financing
Financing activities
• Owner (equity)
• Nonowner (liabilities)
1-15
Investing activities
• Buying resources
• Selling resources
Investing = Financing
Business Activities
FinancingInvesting
1-16
Planning
ActivitiesInvesting
Activities
Financial
Activities
Operating ActivitiesRevenues and expenses from providing
goods and services
Business Activities
1-17
Financial Statements Reflect Business Activities
PlanningInvesting
Current:
• Cash
• Accounts Receivable
• Inventories
• Marketable Securities
Noncurrent:
• Land, Buildings, &
Equipment
• Patents
• Investments
Assets
Balance Sheet
FinancingCurrent:
• Notes Payable
• Accounts Payable
• Salaries Payable
• Income Tax Payable
Noncurrent:
• Bonds Payable
• Common Stock
• Retained Earnings
Liabilities & Equity
Balance Sheet
Statement of
Shareholders’ Equity
Operating
• Sales
• Cost of Goods Sold
• Selling Expense
• Administrative Expense
• Interest Expense
• Income Tax Expense
Net Income
Income statement
Cash Flow
Statement of
Cash Flows
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Financial Statements
Balance Sheet
Income Statement
Statement of Shareholders’ Equity
Statement of Cash Flows
1-19
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Balance Sheet
Total Investing = Total Financing
= Creditor Financing + Owner Financing
Colgate Financing
(in $billions)
$9.138 = $7.727 + $1.410
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Income Statement
Revenues – Cost of goods sold = Gross Profit
Gross profit – Operating expenses = Operating Profit
Colgate’s Profitability
(in $billions)
$12.238 - $5.536 = $6.701 Gross Profit
$6.701 - $4.5411 = $2.160 Operating profit
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1-24
Statement of Cash Flows
Net Cash Flows from Operating Activities
Net Cash Flows from Investing Activities
Net Cash Flows from Financing Activities
1-25
1-26
Additional Information(Beyond Financial Statements)
Management’s Discussion & Analysis (MD&A)
Management Report
Auditor Report
Explanatory Notes to Financial Statements
Supplementary Information
Proxy Statement
1-27
Analysis Preview
Purpose: Evaluation of consecutive
financial statements
Output: Direction, speed, & extent of any
trend(s)
Types: Year-to-year Change Analysis
Index-Number Trend Analysis
Comparative Analysis
Yr2Yr1 Yr3
Analysis Preview
1-28
1-29
Analysis Preview
Purpose : Evaluation of internal makeup
of financial statements
Evaluation of financial statement
accounts across companies
Output: Proportionate size of assets,
liabilities, equity, revenues, &
expenses
Common-Size Analysis
1-30
Analysis Preview
1-31
Analysis Preview
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Analysis Preview
Purpose : Evaluate relation between two or more
economically important items (one
starting point for further analysis)
Output: Mathematical expression of relation
between two or more items
Cautions: Prior Accounting analysis is important
Interpretation is key - long vs short
term & benchmarking
Ratio Analysis
1-33
Analysis Preview
Purpose: Estimate intrinsic value of a
company (or stock)
Basis: Present value theory (time value of
money)
ValuationValuation - an important goal of many types
of business analysis
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Analysis Preview
Debt (Bond) Valuation
Bt is the value of the bond at time t
It +n is the interest payment in period t+n
F is the principal payment (usually the debt’s face value)
r is the investor’s required interest rate (yield to maturity)
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Analysis Preview
Equity Valuation
Vt is the value of an equity security at time t
Dt +n is the dividend in period t+n
k is the cost of capital
E refers to expected dividends
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Analysis Preview
Equity Valuation - Free Cash Flow to Equity
Model
FCFt+n is the free cash flow in the period t + n [often
defined as cash flow from operations less capital
expenditures]
k is the cost of capital
E refers to an expectation
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Analysis Preview
Equity Valuation - Residual Income Model
BVt is the book value at the end of period t
Rit+n is the residual income in period t + n [defined as
net income, NI, minus a charge on beginning
book value, BV, or RIt = NIt - (k x BVt-1)]
k is the cost of capital
E refers to an expectation
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Analysis in an Efficient Market
Three assumed forms of market efficiency
Weak Form - prices reflect information in
past prices
Semi-strong - prices reflect all public
Form information
Strong Form - prices reflect all public and
private information
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Book Organization
Financial Statement Analysis
Part I
Introduction and Overview
Part III
Financial Analysis
Part II
Accounting Analysis
Chapter 1: Overview of
Financial Statement
Analysis
Chapter 2: Financial
Reporting and
Analysis
Chapter 3: Analyzing
Financial Activities
Chapter 4: Analyzing
Investing Activities
Chapter 5: Analyzing
Investing Activities:
Special topic
Chapter 6: Analyzing
Operating Activities
Chapter 7: Cash Flow
Analysis
Chapter 8: Return on
Invested Capital
Chapter 9: Profitability
Analysis
Chapter 10: Prospective
Analysis
Chapter 11: Credit
Analysis
Chapter 12: Equity
Analysis and Valuation
